Regulatory Capital and Liquidity Risk CompliancePierre-Etienne Chabanel – Senior Director, Regulatory SolutionsRobert J. Wyle, CFA - Senior Director, Asset and Liability Management Solutions

Presented at Moody’s Analytics Risk Practitioner Conference; Chicago | October 15-18, 2012

April 11, 2023

Agenda

» The Basel III Reform

» The New Liquidity Risk Requirements

» The Challenges for Financial Institutions

» Regulatory Solutions Demo

– RiskAuthority

– RiskConfidence

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April 11, 2023

Basel III: Major Changes Compared to Basel II

April 11, 2023

Basel II vs. Basel III Capital Ratios

Additional capital ratio buffer (up to 2.5% CET1) for specified G-SIB (SIFIs)

April 11, 2023

Basel III Squeezes Capital!

» More stringent rules on eligible capital

» I.e., Tier 3 not eligible, increased deductions

» RWA will increase for some asset classes

» I.e., OTC derivatives via CVA

» Increased capital ratios

» I.e., Core Tier 1, Tier 1, Buffers

April 11, 2023

0 %

4.5 %

6.0 %

7.0 %

8.5 %

9.5 %

10.5 %11.0 %

13.0 %

RWA Ratio

Calculated Deductions and Adjustments

Basel III Capital Ratios – Own Funds and Deductions

» Basel III capital eligibility and deductions rules are sophisticated

» RWA is only one side of the equation (ratio denominator).

Common Equity Tier 1Requirement

Tier 1Requirement

Tier 1 + Tier 2Requirement

Base

l II

2%

Base

l II

4%

Basel II & III (8%)

Base

l III

4.5%

Base

l III 6%

Cons

erv.

Buffe

r Cons

erv.

Buffe

r

ConservationBuffer (10.5%)

Coun

ter

Cycl

ical

Bu

ffer

Counter Cyclical Buffer (13%)

Elig

ible

Cor

e Ti

er 1

Incl

udin

g M

inor

ity

Inte

rest

s

Coun

ter

Cycl

ical

Bu

ffer

Base

l 2

Addi

tiona

l Ti

er 1

Base

l 3

BII - DeductionsProvision ShortfallGoodwill

BIII - Deductions

Sum of all consolidated holdings

Negative Tier 2

Significant Investments

Tier

2

Adjustment

For Negative Additional Tier 1

B 3

AdditionsProvision Excess

BIII-Deductions

Remaining Significant Investment

Ratio: 11.4%

April 11, 2023

The New Basel III Leverage and Liquidity Ratios

r

A leverage ratio as a non-risk-based metric to avoid excessive leverage

Liquidity risk ratios: a short term ratio (LCR) with a 30 day time horizon anda more long term measure (NSFR) with a 1 year time horizon relying on rules based stress test scenario factors.

Roll out:Tested 2013 to 2017 Binding 2018

Roll out:Tested 2011 to 2014Binding 2015

Roll out:Tested 2012 to 2017Binding 2018

April 11, 2023

Basel III Compliance – Starts This Year

» Capital– 2013 – Counterparty Credit Risk & CVA

– 2015 – Minimum core tier 1 ratio

– 2018 – Capital deductions

– 2019 – New capital ratio buffers

» Leverage

– 2018 – Leverage ratio

» Liquidity– 2015 – Liquidity coverage ratio (LCR)

– 2018 – Net stable funding ratio (NSFR)

April 11, 2023

Which Countries are Implementing Basel II vs. Basel III?

G20 country members are committed to implement Basel III from 2013

April 11, 2023

What Does Basel III Look Like In the U.S.?

» Basel III is one of the many requirements of Dodd Frank (DFA)

» Detailed Basel III NPR on regulatory capital published on June 7th, 2012 (comments expected by Nov 2012, new standardized approach RWA rules by 2015)

» Final Basel II.5 market risk update published June 7th, 2012 as well(application date: 1st of January 2013, one year late)

» New rules for Basel III liquidity ratios and G-SIBs additional capital buffers will be addressed in future proposals

» BIII figures to be reported and forecasted in CCAR (FRY-14)

» Common data requirement between BIII and FRY-14 reports

» FRY-15 reports for G-SIBs

» Single Counterparty Limits requirements

April 11, 2023

U.S. Basel III Breakdown

April 11, 2023

ROW – Basel Committee and FSI Progress Reports

• http://www.bis.org/publ/bcbs220.pdf

• http://www.bis.org/publ/bcbs215.pdf

http://www.bis.org/publ/bcbs/b3prog_dom_impl.htm

• http://www.bis.org/fsi/fsiop2012.pdf

April 11, 2023

Agenda

» The Basel III Reform

» The New Liquidity Risk Requirements

» The Challenges for Financial Institutions

» Regulatory Solutions Demo

– RiskAuthority

– RiskConfidence

13

April 11, 2023

The Context: Systemic Liquidity Mismatches

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April 11, 2023

The Post-Mortem…

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“Measuring and managing bank liquidity risk is as important as capital/solvency risk management, but in the years running up to the crisis did not receive adequate attention, either in the UK or internationally, where debates about bank regulation were dominated by the design of the Basel II capital adequacy standard. It is essential now to restore liquidity regulation and supervision to a position of central importance.”

The Turner Review: A regulatory response to the global banking crisis; March 2009

April 11, 2023

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What Is the Liquidity Coverage Ratio (LCR)?

» LCR Definition

» Objective– To ensure that banks maintain an adequate level of unencumbered, high-quality liquid assets;

– For a 30 calendar day time horizon;

– Under a significantly severe liquidity stress scenario specified by supervisors.

» Numerator - Stock of high quality liquid assets:

– Level 1- Cash, central bank reserves and sovereign paper (from same country and in same currency)

– Level 2- Sovereigns @ 20% RWA, qualifying corporate and covered bonds AA- or higher» haircuts 20%-40% and no more than 40% of total stock of high quality assets

» Net cash outflow over 30 days:

– Net cash outflow under a severe stress scenario (30 day) = outflows – min {inflows, 75% of outflows}

– Stress scenario: significant rating downgrade, partial loss of deposits, loss of unsecured wholesale funding, increase in a) secured funding haircuts, b) collateral calls, c) calls from OBS exposures

– Under this stress scenario, outflows and inflows are calculated according to rules based regulatory factors (i.e. minimum run-off factor of 7.5% for stable deposits)

April 11, 2023

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What Is the Net Stable Funding Ration (NSFR)?

» Definition: – NSFR = Available amount of stable funding / Required amount of stable funding (shall be ≥

100%)

» Objective– To promote more medium and long-term funding of assets

» Available amount of stable funding (ASF)– Sum of: a) Capital, b) preferred shares c) liabilities with effective maturity > 1yr d) stable deposits and

wholesale funding provided by non financial corporate (using appropriate weighting factors)

» Required amount of stable funding (RSF)– Sum of assets and OBS exposures weighted by required stable funding factors (i.e. 0% for cash and

85% for loans to retail)

April 11, 2023

Why Do We Need the New Ratios? Traditional Cash Capital Calculations Were Wrong

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Cash Capital

Required Stable

Funding

Volatile Liability

Dependency

April 11, 2023

The Liquidity Ratios – It’s Just the Beginning

» Liquidity Gap

» Concentration of Funding

» Available Unencumbered Assets

» LCR by Significant Currency

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Liquidity Gap-Report

-600

-400

-200

0

200

400

Cumulative Net Flow

April 11, 2023

Intra-Day Liquidity Management

» “A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems”

» Proposed intraday liquidity indicators:

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April 11, 2023

U.S. Specific Issues Related to Basel III Liquidity

» Sources of Liquidity are Limited– Fannie Mae and Freddie Mac MBS and Debentures:

o Regarded as Level 2 (L2) assets even though they may have better credit characteristics and were demonstrably more liquid than L1 assets during the credit crisis

o Unduly limited because they are capped at 40% of L1 assets

– Federal Home Loan Bank Advances not regarded as source of liquidity in US banks» Increased lending by 50% or $300 billion from 2Q 2007 through 3Q 2008

» Calibration of Basel III Assumptions Are Inconsistent with the U.S. Experience– Decay factors for deposits experienced a maximum outflow of 38% versus an LCR

outflow of 100%

– Assumed draw rates on credit and liquidity facilities were at most 10% during the credit crisis versus a fully drawn LCR assumption (i.e. 100% LCR factor)

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April 11, 2023

US Policy and Market Consequences

» The price and structure of common banking products are likely to change due to discrepancy between bank’s internal liquidity models, empirical evidence, and LCR’s implied outflow rate.– Commercial Paper Back-Stops: Maximum 10% outflow versus 100% LCR coverage

– Financial Institution Liquidity Lines: Maximum 9% outflow versus 100% LCR coverage

– Variable Rate Demand Notes: Maximum 10% outflow versus 100% LCR coverage

– Non Operational Deposits: Maximum 38% outflow versus 100% LCR coverage

» The Basel III liquidity rules have a clear bias toward increased Holdings of Sovereign Debt. This trend will likely increase concentration risk, exert downward pressure on risk free rates, and cause dislocation in market pricing.

» The LCR will force US banks to replace substantial portions of their agency MBS portfolios with US Treasuries. This will adversely impact the US Mortgage Market.

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April 11, 2023

Agenda

» The Basel III Reform

» The New Liquidity Risk Requirements

» The Challenges for Financial Institutions

» Regulatory Solutions Demo

– RiskAuthority

– RiskConfidence

23

April 11, 2023

It’s A Burden. And An Uncertain One.

» Basel III roll out (from draft to production) much quicker than previous Basel reforms

» Many other parallel regulatory initiatives are overwhelming financial institutionscompliance and IT teams– Regulation around OTC derivatives and Clearing Houses (e.g. EMIR in EU)

– Trading platform regulation (e.g. MIFID in EU)

– Voluminous Dodd Frank Financial reforms in the US (e.g. Volcker rules)

– Other regulatory reporting requirements popping up on many different topics(e.g. FSB initiatives, new trade level reports on derivative and asset back securities in EU and in US, new trade level monthly or quarterly reporting required for retail and wholesale business in the US as part of CCAR FRY 14 …)

» Regulatory uncertainty – New guidelines for B3 CCP rules published by BCBS in July

– EU final BIII rules delayed from August to October; deadline is still Jan 1st, 2013?

– A lot of uncertainty concerning possible changes on Basel3 liquidity risk and leverage ratio rules …

April 11, 2023

Regulatory burden and uncertainties

» Cross border institutions will have to simultaneously comply with several Basel regimes and cope with various regulatory “flavors” for each jurisdiction

E.g.: – Basel II (or even Basel I) in some countries and Basel III in others

– IRB for some regulators & Standardized for others that did not rule out IRB yet

– Major US banks will have to compute in parallel IRB and standardized RWA (and the standardized capital requirement will be the new floor replacing Basel I)

– Even if inside the EU there is an effort to standardize rules and reporting requirements;internationally some significant local discrepancies and national discretions will remain (e.g. US prohibiting the use of rating agencies ratings in regulation)

All these uncertainties are a big challenge for banking organizations and IT projects

Some answers:- Banks need to design (or buy) risk management infrastructure and software flexible enough to adapt to a rapidly changing regulatory landscape.- Start by investing in a centralized risk and finance DataMart (as rich as possible)- Avoid data short cuts for maximum flexibility to be able to adapt to new requirements later on- Maintain “agile” program management and governance policies

April 11, 2023

Convergence between risk and finance

» Liquidity ratios require not only asset/liability cash flows, but also counterparty details

E.g.– Securities issuers asset classes, ratings information and standardized risk weight for LCR buffer

– For NSFR, need to identify fully secured mortgage positions – eligible for 35% risk weight

» For leverage ratio, netting is allowed for OTC derivatives and REPO transactions but willfollow the Basel “Current Exposure Approach” used for credit risk RWA => leverage ratio requires information from risk system

» Accurate collateral and guarantee information is a must to optimize regulatory capital and new information is required for Basel III (e.g. inception ratings when hedging securitization)

» Regulators are starting to implement consistency checks between riskand finance regulatory reports (FRY 9C vs FRY 14)

» A holistic view is now required when performing stress testing or when assessing regulatory costs for new trades at origination

April 11, 2023

Convergence between risk and finance

» Consolidating at a financial group level requires information about concentration risk(including direct and indirect risks coming from collateral issuers, guarantors, or funds underlying the assets). This is a big challenge for many institutions.

» New regulatory requirements are challenging for many financial institutions that are still organized into silos, e.g.:– Liquidity risk was traditionally managed by finance/treasury teams in charge of ALM. Risk and compliance

teams now need to be involved.

– Holistic stress testing is very challenging for many institutions. In addition, stress test results are more routinely challenged by regulators.

Some answers:- Create “Basel III” transverse program management organization and governance- Invest in centralized risk and finance DataMart. Focus on data and data quality!- Invest in centralized Enterprise Risk Management system that meets most of the Basel III and Balance Sheet management analytics and reporting requirements - Needs to interface with origination systems and perform holistic stress tests

April 11, 2023

Regulations Just Got More Expensive» Basel III will have a significant impact on the financial services industry and the global

macro economy. Specifically, stronger capital and liquidity standards will hurt profitability, raise lending rates, decrease lending volume, force banks to exit unprofitable businesses, and ultimately, reduce economic output.

» The bulk of the earnings and economic impact will be caused by changes in the quantity and quality of regulatory capital.

Source BCBS QIS results: http://www.bis.org/publ/bcbs217.pdf

April 11, 2023

Increased regulatory costs

» RWA for large banks (Group 1) increased by more than 19%

» Plus a 7% increase in RWA for the new CVA capital charge

» And, additional charges for trades via CCP (and CCP default funds) are pending

April 11, 2023

Additional funding requirement» Changes in liquidity risk regulation will have a noticeable impact as well:

– Anticipated short term liquidity shortfall» Europe: €1.3 Trillion1

» US: €.6 Trillion1

– Anticipated long term liquidity shortfall» Europe: € 2.3 Trillion1

» US: € 2.2 Trillion1

» Balance sheet management will play a crucial role in terms of mitigating the impact of increased capital and liquidity buffers.

» Institutions will need to determine how much of the new requirements can be met internally by raising capital and funding or externally from capital markets.

» To the extent that these resources remain constrained, the focus of balance sheet management will inevitably result in exiting less attractive businesses as measured by RAROC, even if the bank is meeting its internal hurdle rate.

» Efficient allocation of capital and better LRM practices will, in many cases, require investment in more sophisticated risk management systems.

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1Source: Basel III and European banking: Its impact, How Banks might respond, and the challenges of implementation; McKinsey and Company; November 2010

April 11, 2023

What’s the Impact on Return on Equity?

» U.S.– Total US banking sector ROE decrease estimated at 3%.

– With regard to liquidity, the most significant factors include funding sources (inability to collateralize mortgage related assets and recognize FHLB advances), the 40% limit in the LCR for debt issued by public-sector entities, the assumed draw-downs for corporate and financial credit and liquidity lines, and assumed runoff rates for wholesale deposits.

» Europe– Pretax ROE for European banks to all Basel II requirements are estimated to decrease between

3.7% and 4.3 % from the pre-crisis level of 15%.

– Effect to be felt only gradually over a period of years i.e. .3% by 2013 and 2.1% by 2016

– Liquidity impact estimated at .2% ROE for short term funding and .6% ROE for long term funding

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April 11, 2023

Agenda

» The Basel III Reform

» The New Liquidity Risk Requirements

» The Challenges for Financial Institutions

» Regulatory Solutions Demo

– RiskAuthority

– RiskConfidence

32

April 11, 2023

RiskAuthority Delivers End-to-End Basel I/II/III Compliance

April 11, 2023

Data Modeling, Capital Requirements, Regulatory Ratios & Regulatory Reporting

RiskAuthority

April 11, 2023

RiskConfidence

April 11, 2023

Why RiskAuthority? Preserve Existing Investments

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Use provided configuration files per supervisor AndPlug any existing Cash-Flows Provider to Compute Regulatory Ratios

RiskAuthority™ Liquidity ComplianceRegulatory rules & reporting

Scenario Analyzer™

Buffer Content Stress Testing

External cash-flows providers

April 11, 2023

Why RiskAuthority? It’s An Enterprise Liquidity Risk Solution

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RiskAuthority™ Liquidity ComplianceRegulatory rules & reporting

RiskConfidence™ Liquidity Monitoring

Internal liquidity models

Scenario Analyzer™

HolisticStress testing

Compute Regulatory Ratios Based on Banks’ Own Stress Assumptions and Liquidity Models (What If?)

And/Or

Compute Liquidity Standards Based on Liquidity Cash-flows provided by our Liquidity Monitoring product

April 11, 2023

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